Barbarians at the Monetary Gate
Amid global fears of financial instability, cybercurrencies are becoming a refuge for skeptical investors. But as peer-to-peer alternatives to official money proliferate, and the state loses its role in maintaining currency values, the risks to financial stability implied by a collapse are rising.
HONG KONG – Financial markets today are thriving. The Dow Jones industrial average, the S&P 500, and the Nasdaq composite index have all reached record highs lately, with emerging-economy financial markets also performing strongly, as investors search for stability amid widespread uncertainty. But, because this performance is not based on market fundamentals, it is unsustainable – and very risky.
According to Mohamed El-Erian, the lost lesson of the 2007 financial crisis is that current economic-growth models are “overly reliant on liquidity and leverage – from private financial institutions, and then from central banks.” And, indeed, a key driver of financial markets’ performance today is the expectation of continued central-bank liquidity.
After the US Federal Reserved revealed its decision last month to leave interest rates unchanged, the Dow Jones industrial average set intraday and closing records; the Nasdaq, too, reached all-time highs. Now, financial markets are waiting for signals from this year’s meeting of the world’s major central bankers in Jackson Hole, Wyoming.
But there is another factor that could further destabilize an already-tenuous leverage- and liquidity-based system: digital currencies. And, on this front, policymakers and regulators have far less control.
The concept of private cryptocurrencies was born of mistrust of official money. In 2008, Satoshi Nakamoto – the mysterious creator of bitcoin, the first decentralized digital currency – described it as a “purely peer-to-peer version of electronic cash,” which “would allow online payments to be sent directly from one party to another without going through a financial institution.”
A 2016 working paper by the International Monetary Fund distinguished digital currency (legal tender that could be digitized) from virtual currency (non-legal tender). Bitcoin is a cryptocurrency, or a kind of virtual currency that uses cryptography and distributed ledgers (the blockchain) to keep transactions both public and fully anonymous.
However you slice it, the fact is that, nine years after Nakamoto introduced bitcoin, the concept of private electronic money is poised to transform the financial-market landscape. This month, the value of bitcoin reached $4,483, with a market cap of $74.5 billion, more than five times larger than at the beginning of 2017. Whether this is a bubble, destined to collapse, or a sign of a more radical shift in the concept of money, the implications for central banking and financial stability will be profound.
At first, central bankers and regulators were rather supportive of the innovation represented by bitcoin and the blockchain that underpins it. It is difficult to argue that people should not be allowed to use a privately created asset to settle transactions without the involvement of the state.
But national authorities were wary of potential illegal uses of such assets, reflected in the bitcoin-enabled, dark-web marketplace called Silk Road, a clearinghouse for, among other things, illicit drugs. Silk Road was shut down in 2013, but more such marketplaces have sprung up. When the bitcoin exchange Mt. Gox failed in 2014, some central banks, such as the People’s Bank of China, started discouraging the use of bitcoin. By November 2015, the Bank for International Settlements’ Committee on Payments and Market Infrastructures, made up of ten major central banks, launched an in-depth examination of digital currencies.
But the danger of cryptocurrencies extends beyond facilitation of illegal activities. Like conventional currencies, cryptocurrencies have no intrinsic value. But, unlike official money, they also have no corresponding liability, meaning that there is no institution like a central bank with a vested interest in sustaining their value.
Instead, cryptocurrencies function based on the willingness of people engaged in transactions to treat them as valuable. With the value of the proposition depending on attracting more and more users, cryptocurrencies take on the quality of a Ponzi scheme.
As the scale of cryptocurrency usage expands, so do the potential consequences of a collapse. Already, the market capitalization of cryptocurrencies amounts to nearly one tenth the value of the physical stock of official gold, with the capability to handle significantly larger payment operations, owing to low transaction costs. That means that cryptocurrencies are already systemic in scale.
There is no telling how far this trend will go. Technically, the supply of cryptocurrencies is infinite: bitcoin is capped at 21 million units, but this can be increased if a majority of “miners” (who add transaction records to the public ledger) agree. Demand is related to mistrust of conventional stores of value. If people fear that excessive taxation, regulation, or social or financial instability places their assets at risk, they will increasingly turn to cryptocurrencies.
Last year’s IMF report indicated that cryptocurrencies have already been used to circumvent exchange and capital controls in China, Cyprus, Greece, and Venezuela. For countries subject to political uncertainty or social unrest, cryptocurrencies offer an attractive mechanism of capital flight, exacerbating the difficulties of maintaining domestic financial stability.
Moreover, while the state has no role in managing cryptocurrencies, it will be responsible for cleaning up any mess left by a burst bubble. And, depending on where and when a bubble bursts, the mess could be substantial. In advanced economies with reserve currencies, central banks may be able to mitigate the damage. The same may not be true for emerging economies.
An invasive new species does not pose an immediate threat to the largest trees in the forest. But it doesn’t take long for less-developed systems – the saplings on the forest floor – to feel the effects. Cryptocurrencies are not merely new species to watch with interest; central banks must act now to rein in the very real threats they pose.
The Bitcoin Threat
Unless a currency has been authenticated by a government, it is unlikely to be fully trusted. But that does not mean that it cannot become a plaything for the naïve and gullible, or a weapon of financial mass destruction for political belligerents around the world.
LONDON – The extraordinary volatility of Bitcoin and other cryptocurrencies has become a threat not just to the international financial system, but also to political order. The blockchain technology upon which cryptocurrencies are based promises a better and more secure payment method than anything seen before, and some believe that cryptocurrencies will replace electronic currency in traditional bank accounts, just as electronic transfers replaced paper money, which succeeded gold and silver.
But others are rightly suspicious that this new technology might be manipulated or abused. Money is part of the social fabric. For most of the history of human civilization, it has provided a basis for trust between people and governments, and between individuals through exchange. It has almost always been an expression of sovereignty as well, and private currencies have been very rare.
In the case of metallic money, coins typically bore emblems of state identity, one of the earliest examples being the owl symbolizing the city of Athens. Usually, however, there was some confusion about whether the emblems on coins represented sovereignty or divinity. Whose head is on this coin? Is it Philip of Macedon or Alexander the Great, or is it Hercules? Later, Roman emperors would exploit this ambiguity, by stamping coins with their own “divine” visage. And even today, British coins have embossed words linking the monarchy to God.
Whatever the case, there is a clear pattern throughout history: bad states produce bad money, and bad money leads to failed states. During periods of inflation or hyperinflation, radical currency devaluation would destroy the basis of political order. For example, the Thirty Years’ War in Central Europe during the seventeenth century was fueled in large part by social disintegration following a period of monetary instability.
Similarly, during the French Revolution, speculation in a paper currency pegged to “national” property that had been confiscated from aristocrats and the church undermined the Jacobins’ legitimacy. In the twentieth century, periods of inflation during and after the two world wars destroyed Europe’s political institutions and fanned the flames of radicalism. In fact, Vladimir Lenin regarded the currency press as the “simplest way to exterminate the very spirit of capitalism” and bourgeois democracy.
In addition to being one of the main factors behind the disintegration of states, bad money has also been a key feature of interstate conflicts. For belligerent states, creating or exploiting monetary turmoil has historically been a cheap way to destroy opponents. Even in peacetime, some states have responded to deteriorating relations by planting fake money to sow discord beyond their borders.
The best-known example of such monetary warfare is Nazi Germany’s scheme to print the banknotes of Allied powers during World War II. Counterfeit notes could of course be used to purchase scarce resources or pay spies. But Germany also envisioned using long-range bombers to drop forged banknotes over Britain. Just imagine the demoralization and chaos that would have followed. Anyone with a large amount of money would automatically be suspect, and public trust would quickly erode. Dropping money could very well be more devastating than dropping bombs.
Money is even easier to manipulate when it is internationalized. In the modern era, rogue states such as North Korea have regularly forged banknotes, particularly those of the United States. And cross-border electronic transfers between banks are often used for malign and criminal purposes. So far, though, there have not been any globally devastating monetary attacks outside the realm of cinematic fantasy.
Of course, there have long been political efforts to undermine or replace the dollar as the dominant global currency. The most seductive alternative seems to have been gold. Russian theorists of “Eurasia” often tout traditional Russian iconography’s use of the fine metal. In 2001, then-Malaysian Prime Minister Mahathir Mohamad tried to introduce a “gold dinar” as an answer to the US-based currency system. And in 2005, al-Qaeda’s security chief, Saif al-Adl, suggested using gold to topple the dollar.
Bitcoin looks like a twenty-first-century version of gold, and its creators have even embraced that analogy. It is produced – or “mined” – through effort. And just as the price of gold once reflected the human exertion needed to extract it from the ground in remote locations, creating Bitcoins takes an exorbitant amount of computing power, driven by cheap energy in remote areas of Asia or Iceland.
But the rise of Bitcoin represents a shift in how society perceives fundamental value. Whereas pre-modern metallic currencies served as a basis for the labor theory of value – whereby goods and services are worth the amount of human labor put into them – blockchain technology assigns value to a combination of computing power and stored energy, none of it human.
At the same time, cryptocurrencies like Bitcoin have made it all but impossible to distinguish between state and private-sector criminality. North Korea has been suspected of continuing its attempts at monetary manipulation by mining and creating Bitcoin, which has led China and South Korea to start closing down Bitcoin exchanges. Major cryptocurrency platforms such as Coincheck in Japan have also put a halt to trading.
And yet we have already reached the point where a Bitcoin crash could have serious global implications. Financial institutions’ current exposure to the cryptocurrency is unclear, and probably would not be fully revealed until after a financial disaster. It is eerily reminiscent of 2007 and 2008, when no one really knew where the exposure to subprime-mortgage debt ultimately lay. Until the crash, it was anyone’s guess which institutions might be insolvent.
Just as one cannot instantly tell whether a news report is “fake news,” nor can one immediately discern the validity of new monetary forms. Unless a currency has been authenticated by a government, it is unlikely to be fully trusted. But that does not mean that it cannot become a plaything for the naïve and gullible, or a weapon of financial mass destruction for political belligerents around the world.
Should You Buy Bitcoin?
Over the next year, the Bitcoin price could double, soar tenfold, or collapse by 95% or more, and no economic analysis can help predict where in that range it will lie. Like other cryptocurrencies, Bitcoin serves no useful economic purpose, though in macroeconomic terms, such currencies probably also do little harm.
LONDON – In December, as the Bitcoin price neared $20,000, a friend asked me whether she should invest. I said that I hadn’t the faintest idea. Today, with the price below half that, my reply remains the same.
Over the next year, the Bitcoin price could double, soar tenfold, or collapse by 95% or more, and no economic analysis can help predict where in that range it will lie. Its value is arbitrarily determined by the collective psychology of the mass of investors; it goes where, on average, they think it will. Like other cryptocurrencies, Bitcoin serves no useful economic purpose, though in macroeconomic terms, such currencies probably also do little harm.
In a modern economy, money has a well-defined real value because governments accept it as payment of taxes and issue debts in defined monetary amounts, and because central banks ensure that total monetary creation, by either the state or the private banking system, grows at a pace compatible with relatively low and stable inflation. In some sense, money is an arbitrary social construct; but its value and ability to serve crucial economic functions are rooted in the authority and institutions of the currency-issuing state.
At any time, however, groups of individuals can choose to believe that some commodity – a specific type of seashell, or gold, or tulips – will be a far better store of value than money, and that its value in money terms is bound to rise. What matters is simply that the supply of the chosen commodity cannot be rapidly and limitlessly increased. Provided that is the case, the price can be whatever speculators believe. In early 1636, a pound of “switsers” (a particular category of tulip bulb) traded in Dutch markets for 60 guilders; by mid-February 1637, the price was 1,500 guilders. In the subsequent crash, some bulb prices fell 99%.
Unlike gold or tulips, whose supply is fixed in the short term and constrained by nature in the medium term, immaterial Bitcoin could in principle be created in infinite quantities. In fact, the currency’s supply is limited by clever software algorithms, supported by huge quantities of computing power, which have enabled Bitcoin’s creators to achieve a previously impossible trinity: decentralized “mining,” collectively limited aggregate supply, and anonymity.
In theory, the latter could allow Bitcoin or other cryptocurrencies to be not only an arbitrary store of value, but also an anonymous medium of exchange for large-value transactions, just like suitcases full of high-denomination dollar bills, with no mark identifying the owner, but now in digital form. But, as Kenneth Rogoff has argued, anonymous large-denomination notes play no useful role in legitimate commerce. They are, however, the favored medium of exchange for drug lords, tax avoiders, terrorists, and other criminals. But if, as Rogoff argues, there is therefore a good case for eliminating them, the last thing the world needs is to recreate the same problem in digital form.
South Korea has therefore banned the anonymous trading of cryptocurrencies, and other regulators around the world are considering whether to do the same. The best case for going further and banning cryptocurrencies entirely is actually environmental. Estimates of how much electricity Bitcoin mining requires vary widely – some put it as high as 30 terawatt hours per year (equivalent to Morocco’s entire electricity demand), while others suggest it’s a sixth of that. But whatever the true quantity, the related carbon dioxide emissions are adding to global warming, in return for no social benefit.
At the same time, fears that speculative bubbles in cryptocurrencies could drive macroeconomic instability appear overstated. As Charles Kindelberger showed in his classic historical survey Manias, Panics, and Crashes, speculative bubbles and subsequent crashes sometimes lead to post-crash depressions. But not always: whereas the Wall Street boom of the 1920s ended in the Great Depression, the tulip bubble of the 1630s seems to have had little impact on the Netherlands’ medium-term growth path.
What matters is the scale of the boom, and whether it is financed with debt. Booms and busts in individual equity stocks or specific commodities typically have little macro-level effect: and even huge swings in entire equity-market sectors – such as the NASDAQ boom and bust of 1998-2002 – may have only a mild adverse impact on overall economic growth. By contrast, property booms and busts have historically been the most dangerous, because the total value of real estate wealth usually dwarfs equity values, and because real-estate booms are often debt-financed.
Regulators should therefore keep a careful eye on any credit-financed cryptocurrency speculation. But with total cryptocurrency values still equal to just a minute fraction of global real-estate wealth, the overall risk remains slight. Some individual investors will certainly lose their shirts, but the impact on economic growth will most likely be close to nil.
The wider social challenge, however, is to channel human ingenuity into welfare-boosting innovation rather than zero-sum gambling activities. The distributed-ledger technology underpinning cryptocurrencies can be used to reduce transaction costs and eliminate risks across multiple financial and trading activities. That would be worth doing.
As for whether you should invest in Bitcoin, I cannot say. Personally, I would rather buy a lottery ticket.
The price of Bitcoin is up 600% over the past 12 months, and 1,600% in the past 24 months. But the long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates – and there is no reason to expect virtual currency to avoid a similar fate.
CAMBRIDGE – Is the cryptocurrency Bitcoin the biggest bubble in the world today, or a great investment bet on the cutting edge of new-age financial technology? My best guess is that in the long run, the technology will thrive, but that the price of Bitcoin will collapse.
If you haven’t been following the Bitcoin story, its price is up 600% over the past 12 months, and 1,600% in the past 24 months. At over $4,200 (as of October 5), a single unit of the virtual currency is now worth more than three times an ounce of gold. Some Bitcoin evangelists see it going far higher in the next few years.
What happens from here will depend a lot on how governments react. Will they tolerate anonymous payment systems that facilitate tax evasion and crime? Will they create digital currencies of their own? Another key question is how successfully Bitcoin’s numerous “alt-coin” competitors can penetrate the market.
In principle, it is supremely easy to clone or improve on Bitcoin’s technology. What is not so easy is to duplicate Bitcoin’s established lead in credibility and the large ecosystem of applications that have built up around it.
For now, the regulatory environment remains a free-for-all. China’s government, concerned about the use of Bitcoin in capital flight and tax evasion, has recently banned Bitcoin exchanges. Japan, on the other hand, has enshrined Bitcoin as legal tender, in an apparent bid to become the global center of fintech.
The United States is taking tentative steps to follow Japan in regulating fintech, though the endgame is far from clear. Importantly, Bitcoin does not need to win every battle to justify a sky-high price. Japan, the world’s third largest economy, has an extraordinarily high currency-to-income ratio (roughly 20%), so Bitcoin’s success there is a major triumph.
In Silicon Valley, drooling executives are both investing in Bitcoin and pouring money into competitors. After Bitcoin, the most important is Ethereum. The sweeping, Amazon-like ambition of Ethereum is to allow its users to employ the same general technology to negotiate and write “smart contracts” for just about anything.
As of early October, Ethereum’s market capitalization stood at $28 billion, versus $72 billon for Bitcoin. Ripple, a platform championed by the banking sector to slash transaction costs for interbank and overseas transfers, is a distant third at $9 billion. Behind the top three are dozens of fledgling competitors.
Most experts agree that the ingenious technology behind virtual currencies may have broad applications for cyber security, which currently poses one of the biggest challenges to the stability of the global financial system. For many developers, the goal of achieving a cheaper, more secure payments mechanism has supplanted Bitcoin’s ambition of replacing dollars.
But it is folly to think that Bitcoin will ever be allowed to supplant central-bank-issued money. It is one thing for governments to allow small anonymous transactions with virtual currencies; indeed, this would be desirable. But it is an entirely different matter for governments to allow large-scale anonymous payments, which would make it extremely difficult to collect taxes or counter criminal activity. Of course, as I note in my recent book on past, present, and future currencies, governments that issue large-denomination bills also risk aiding tax evasion and crime. But cash at least has bulk, unlike virtual currency.
It will be interesting to see how the Japanese experiment evolves. The government has indicated that it will force Bitcoin exchanges to be on the lookout for criminal activity and to collect information on deposit holders. Still, one can be sure that global tax evaders will seek ways to acquire Bitcoin anonymously abroad and then launder their money through Japanese accounts. Carrying paper currency in and out of a country is a major cost for tax evaders and criminals; by embracing virtual currencies, Japan risks becoming a Switzerland-like tax haven – with the bank secrecy laws baked into the technology.
Were Bitcoin stripped of its near-anonymity, it would be hard to justify its current price. Perhaps Bitcoin speculators are betting that there will always be a consortium of rogue states allowing anonymous Bitcoin usage, or even state actors such as North Korea that will exploit it.
Would the price of Bitcoin drop to zero if governments could perfectly observe transactions? Perhaps not. Even though Bitcoin transactions require an exorbitant amount of electricity, with some improvements, Bitcoin might still beat the 2% fees the big banks charge on credit and debit cards.
Finally, it is hard to see what would stop central banks from creating their own digital currencies and using regulation to tilt the playing field until they win. The long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates. I have no idea where Bitcoin’s price will go over the next couple years, but there is no reason to expect virtual currency to avoid a similar fate.
Blockchain’s Broken Promises
Boosters of blockchain technology compare its early days to the early days of the Internet. But whereas the Internet quickly gave rise to email, the World Wide Web, and millions of commercial ventures, blockchain's only application – cryptocurrencies such as Bitcoin – does not even fulfill its stated purpose.
NEW YORK – The financial-services industry has been undergoing a revolution. But the driving force is not overhyped blockchain applications such as Bitcoin. It is a revolution built on artificial intelligence, big data, and the Internet of Things.
Already, thousands of real businesses are using these technologies to disrupt every aspect of financial intermediation. Dozens of online-payment services – PayPal, Alipay, WeChat Pay, Venmo, and so forth – have hundreds of millions of daily users. And financial institutions are making precise lending decisions in seconds rather than weeks, thanks to a wealth of online data on individuals and firms. With time, such data-driven improvements in credit allocation could even eliminate cyclical credit-driven booms and busts.
Similarly, insurance underwriting, claims assessment and management, and fraud monitoring have all become faster and more precise. And actively managed portfolios are increasingly being replaced by passive robo-advisers, which can perform just as well or better than conflicted, high-fee financial advisers.
Now, compare this real and ongoing fintech revolution with the record of blockchain, which has existed for almost a decade, and still has only one application: cryptocurrencies. Blockchain’s boosters would argue that its early days resemble the early days of the Internet, before it had commercial applications. But that comparison is simply false. Whereas the Internet quickly gave rise to email, the World Wide Web, and millions of viable commercial ventures used by billions of people, cryptocurrencies such as Bitcoin do not even fulfill their own stated purpose.
As a currency, Bitcoin should be a serviceable unit of account, means of payments, and a stable store of value. It is none of those things. No one prices anything in Bitcoin. Few retailers accept it. And it is a poor store of value, because its price can fluctuate by 20-30% in a single day.
Worse, cryptocurrencies in general are based on a false premise. According to its promoters, Bitcoin has a steady-state supply of 21 million units, so it cannot be debased like fiat currencies. But that claim is clearly fraudulent, considering that it has already forked off into three branches: Bitcoin Cash, Litecoin, and Bitcoin Gold. Besides, hundreds of other cryptocurrencies are invented every day, alongside scams known as “initial coin offerings,” which are mostly designed to skirt securities laws. So “stable” cryptos are creating money supply and debasing it at a much faster pace than any major central bank ever has.
As is typical of a financial bubble, investors are buying cryptocurrencies not to use in transactions, but because they expect them to increase in value. Indeed, if someone actually wanted to use Bitcoin, they would have a hard time doing so. It is so energy-intensive (and thus environmentally toxic) to produce, and carries such high transaction costs, that even Bitcoin conferences do not accept it as a valid form of payment.
Until now, Bitcoin’s only real use has been to facilitate illegal activities such as drug transactions, tax evasion, avoidance of capital controls, or money laundering. Not surprisingly, G20 member states are now working together to regulate cryptocurrencies and eliminate the anonymity they supposedly afford, by requiring that all income- or capital-gains-generating transactions be reported.
After a crackdown by Asian regulators this month, cryptocurrency values fell by 50% from their December peak. They would have collapsed much more had a vast scheme to prop up their price via outright manipulation not been rapidly implemented. But, like in the case of the sub-prime bubble, most US regulators are still asleep at the wheel.
Since the invention of money thousands of years ago, there has never been a monetary system with hundreds of different currencies operating alongside one another. The entire point of money is that it allows parties to transact without having to barter. But for money to have value, and to generate economies of scale, only so many currencies can operate at the same time.
In the US, the reason we do not use euros or yen in addition to dollars is obvious: doing so would be pointless, and it would make the economy far less efficient. The idea that hundreds of cryptocurrencies could viably operate together not only contradicts the very concept of money; it is utterly idiotic.
But so, too, is the idea that even a single cryptocurrency could substitute for fiat money. Cryptocurrencies have no intrinsic value, whereas fiat currencies certainly do, because they can be used to pay taxes. Fiat currencies are also protected from value debasement by central banks committed to price stability; and if a fiat currency loses credibility, as in some weak monetary systems with high inflation, it will be swapped out for more stable foreign fiat currencies or real assets.
As it happens, Bitcoin’s supposed advantage is also its Achilles’s heel, because even if it actually did have a steady-state supply of 21 million units, that would disqualify it as a viable currency. Unless the supply of a currency tracks potential nominal GDP, prices will undergo deflation.
That means if a steady-state supply of Bitcoin really did gradually replace a fiat currency, the price index of all goods and services would continuously fall. By extension, any nominal debt contract denominated in Bitcoin would rise in real value over time, leading to the kind of debt deflation that economist Irving Fisher believed precipitated the Great Depression. At the same time, nominal wages in Bitcoin would increase forever in real terms, regardless of productivity growth, adding further to the likelihood of an economic disaster.
Clearly, Bitcoin and other cryptocurrencies represent the mother of all bubbles, which explains why every human being I met between Thanksgiving and Christmas of 2017 asked me if they should buy them. Scammers, swindlers, charlatans, and carnival barkers (all conflicted insiders) have tapped into clueless retail investors’ FOMO (“fear of missing out”), and taken them for a ride.
As for the underlying blockchain technology, there are still massive obstacles standing in its way, even if it has more potential than cryptocurrencies. Chief among them is that it lacks the kind of basic common and universal protocols that made the Internet universally accessible (TCP-IP, HTML, and so forth). More fundamentally, its promise of decentralized transactions with no intermediary authority amounts to an untested, Utopian pipedream. No wonder blockchain is ranked close to the peak of the hype cycle of technologies with inflated expectations.
So, forget about blockchain, Bitcoin, and other cryptocurrencies, and start investing in fintech firms with actual business models, which are slogging away to revolutionize the financial-services industry. You won’t get rich overnight; but you’ll have made the smarter investment.